Key Diagrams - Producer Subsidies (Supply and Demand Analysis)

In this video we walk through how to draw an analysis diagram showing the effect of a producer subsidy using supply and demand analysis.

A subsidy is a form of government intervention in the price mechanism designed to change market prices and alter the allocation of scarce resources. A subsidy means the government pays part of the cost – for example the government might decide to subsidise some of the manufacturing costs of firms producing battery-powered and hybrid plug-in electric vehicles.

The subsidy shifts the supply curve for electric cars to the right. Ceteris paribus, this leads to a lower equilibrium market price andan expansion of quantity demand increases from Q1 to Q2. Lower prices increase the real incomes of consumers and might help to make electric cars more affordable.

It is important to show in a supply and demand diagram the total government spending on the subsidy because this will be a key part of your evaluation. The state spending = output x the subsidy per unit. Subsidies can be expensive and may have to be financed either by higher government borrowing or funded through an increase in taxes.

The impact of a subsidy depends in part on the coefficient of price elasticity of demand as well as the generosity of the subsidy being offered to suppliers. In the next diagram, demand is drawn as highly price elastic. The same subsidy per unit this time leads to a much larger expansion of demand which in turn will increase government spending on the subsidy.